Unit 7 Cost Accumulation Techniques

7.1 Absorption and Variable Costing

1. Absorption Costing (Full Absorption)

This method includes all costs of manufacturing. Under this method the MOH Fixed is absorbed
into the Product Cost (capitalized). Used for External reporting purposes and Tax purposes.
(GAAP & IFRS)
The following are included in the Product Cost (capitalized)
Direct Materials (variable)
Direct Labor (variable)
MOH (variable)
MOH (fixed)

The following are included in Period Costs (expensed)

Selling & Administrative (variable)
Selling & Administrative (fixed)

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 • Under absorption costing, the fixed
portion of MOH is charged/absorbed
by each unit of product.

• The Product Cost includes Fixed &

Variable MOH

• Gross Margin exists

2. Variable Costing (Direct Costing)

Variable Costs are direct function of production volume. They increase as production increase.
Under this method the MOH Fixed is treated as Period Cost (expensed). Used for Internal
reporting purposes, to improve decisions in the short run. (Not accepted under GAAP & IFRS)
The following are included in the Product Cost (capitalized)
Direct Materials (variable)
Direct Labor (variable)
MOH (variable)

The following are included in Period Costs (expensed)

MOH (fixed)
Selling & Administrative (variable)
Selling & Administrative (fixed)

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The main benefit of Variable Costing over Absorption is that income cannot be manipulated by
the management.

3. Effect on Operating Income and Ending Inventory

As the production and sales level change, both methods illustrate different operating income.
There are 3 cases:
1) Produced = Sold
If everything produced during a period was sold, both methods will have the same operating
income, as total fixed costs under both methods are charged to the sales revenue in the same
period. No Ending Inventory.

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 2) Produced > Sold
Under this method, the business, produced more than the units sold,
so there is ending inventory. The ending inventory under absorption
costing has incurred fixed costs. The sold units have incurred a part
of the fixed costs as well and recorded in the Income Statement.
However, under variable costing doesn’t take this into account as the
fixed costs are expensed.

3) Produced < Sold

Under this method, the business sold more than the produced amount,
so the extra amounts are from the ending inventory from the previous
year. So the Income Statement for this year has incurred the fixed
costs for this year and the fixed costs of the previous year. However,
under variable costing doesn’t take this into account as the fixed costs
are expensed.

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Companies prefer variable costing for internal reporting as it keeps managers in line. When the
Production > Sale (fewer fixed costs are expensed under absorption basis and Operating Income
is always higher). A production manager can increase the production basis, by increasing
production even if customer demands do not match, which will result in increasing
carrying/warehouse costs to store the inventory. This process is called producing for inventory,
which is discouraged by Variable Costing.

The value of ending inventory is never higher when following variable costing, in contrast to
absorptions costing as Fixed MOH are not included in inventory for variable costing.
Income and inventory will differ whenever sales and production differ:
a. If inventory increased during a period, variable costing method will show lower
income as fixed costs are subtracted from the Income Statement, however, under
absorption costing, some fixed costs are being capitalized as inventories
b. Variable Costing will show higher income when inventories decreases, as under
absorption, current period fixed costs are subtracted with prior periods.
Under variable costing, Profits always move in the same direction as Sales, opposite to
absorption costing.

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 4. Advantages and Disadvantages
Absorption Costing
Advantages
✓ Provides matching of costs and revenues of a specific period
✓ Absorption costing is consistent with GAAP and Tax Authorities for reporting Income

Disadvantages
❖ This method gives an opportunity for plant managers to manipulate the Operating Income
reported as they can over produce to keep a part of the fixed costs into the inventory in
the balance sheet (producing for inventory)

Variable Costing
Advantages
✓ Gross Profit fluctuates with sales
✓ When not including fixed costs in the calculation, management can take better decisions
about profitability and product mix
✓ It is easier to determine the contribution to fixed costs made by a product and therefore
determine of an operation needs to be discontinued

Disadvantages
❖ Variable Costing does not provide proper matching of costs and revenue
❖ It does not comply with GAAP or Tax Authorities

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7.2 Joint Product and By Product Costing

When two or more separate products are produced from the same manufacturing process
(common inputs).
Joint (common) costs- costs incurred till the split off point (where products are separated). They
include DM, DL and MOH, these costs must be allocated to specific products as they are not
separately identified.
Joint Product- products that are separately identified at split-off point
Separable Costs- are costs allocated to a specific unit after the split-off point
By-Product- products that are small in quantity, produced simultaneously from a specific
manufacturing process (aim is not to produce them)

The decision is to sell, or further process based on the predicted

revenue to be gained if it exceeds the predicted cost. Joint Costs are not
considered/irrelevant to make the decision as its considered sunk cost
(already paid whether sold or further processed)

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 1. Methods to Allocate Costs
Since joint costs cannot be traced to an individual product they must be allocated using the
following methods to determine the inventory cost. There are 2 approaches which include
physical measure based approach (by volume, weight, linear measure) or market based
approach (by assigning the total costs in a proportionally on a monetary basis)
1) Physical-Measure Based Approach
2) Sales-Value at split-off method
3) Estimated NRV method
4) Constant Gross Margin % (NRV method)

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 1) Physical-Measure Based Approach

2) Sales-Value at split-off method

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 3) Estimated NRV method (Sales – Selling Costs)

4) Constant Gross Margin % (NRV method)

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 2. By Products
These are products that are small in quantity (compared to the joint product), produced
simultaneously from a specific manufacturing process. “Benefits VS Costs”
There are 2 main situations:
1) If by-product is immaterial
Amount is not recognized at the point of sale.

2) If by product is material
They must be capitalized into a separate inventory account.
a. No Sale (scrap)

b. Sale = Net Realizable Value

c. Further Processing

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7.3 Overhead Allocation and Normal Costing

MOH consists of all costs of manufacturing that are not directly related to DM or DL.
a. Indirect Materials- tangible inputs related to manufacturing that cannot be traced to the
product (ex- oil used in machine)

b. Indirect Labor- cost incurred of human labor manufacturing that cannot be traced to the
product (ex- supervisor or janitors)

c. Factory Operating Costs- ex- utilities, taxes, insurance, depreciation on equipment

(costs to run the plant/factory only, not related to the office)

DM and DL are variable costs that increase or decrease depending on the production. MOH
contains:
a. Variable MOH- include Indirect Materials, Indirect Labor, utilities and depreciation
related to the output (ex- if depreciation is by units produced not passage of time). Time
frame for variable MOH is short run

b. Fixed MOH- include taxes, insurances and depreciation not related to output (ex-
depreciation by passage of time SLN or DDB). The time frame for fixed MOH is long
run.
Estimated MOH (Applied) is accumulated into 2 cost pools (variable and fixed), then allocated
by using Allocation Base.

In order to accurate when allocating MOH costs, the cost pools must be homogenous (similar).
After creating the cost pools, allocation is done based on it. The key is in (cause-and-effect)
between the cost driver and allocation costs.
a. Labor Intensive- costs driver is appropriate direct hours or direct labor cost
b. Capital Intensive- machine hour is appropriate
MOH costs are usually not allocated to the units produced as it lacks cause-and-effect relation.
Budgeted numbers are used as the real costs are not available till the end of the year.

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 1. Over and Under Applied Overhead
MOH applied during the year will differ from the actual incurred. This difference is called
variance.
✓ In case the amount of over or under applied is immaterial, it should be allocated to
COGS
✓ If the amount of over or under applied is material, it should be allocated relatively
among WIP, FG and COGS (most accurate method)

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Example

2. Calculating the Application Rate

Once the allocation base was selected, the application rate must be calculated. There are 3 ways
to estimate the allocation base based on the capacity levels:
1) Normal Capacity- long term average level of activity, meets the demands of seasons,
trends variation. Deviations (differences) are offset in the subsequent years

2) Practical Capacity- max level of output, efficiently produced. It allows delays,

maintenance, holidays, etc. Based on realistic and attainable levels. It is the most
appropriate level as denominator for application rate

3) Theoretical (ideal) Capacity- max capacity assuming no maintenance, holiday, etc. No

realistic.
Normal < Practical < Theoretical
The Fixed MOH using the allocation base, rather than recognizing one-twelfth of the estimated
amounts each month. Fixed MOH costs must be covered by the selling products to customers.
The advantage of applying Fixed MOH at a specific rate is that allocation base reflects the
productive activity. If the production is up or down, it would be reflected in fixed overhead
production-volume variance (denominator-level variance). The existence of this system alerts
management to the fact that Fixed MOH is spread over more or less units.
Under ABC, individual costs are applied based on the level of activity rather than lump-sum.

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Departmental VS Plant Wide Rate

Plant-Wide Allocation Rate- uses a single cost driver

for the entire firm despite the departments involved,
single cost pool.

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Departmental Allocation Rate- separate costs by
departments not fixed or variable MOH. (More
accurate)

Calculating a new rate for the MOH each month can be misleading. This is because during the
low production months, the per-unit MOH charges will skyrocket, which leads to higher product
costs and distortion in the Financial Statements.
To avoid these distortions, Normal Costing is derived based on an approach of the entire year.
Extended Normal Costing applies normalized rate to direct costs as well as manufacturing
overhead

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7.4 Allocating Service Department Costs

The Shared Service Department/Shared Services (Support) are department costs and are
considered part of MOH (indirect costs). They cannot be feasibly traceable to the cost object and
must be allocated to the operating departments that use the service.
For Internal Reporting and decision making, the costs of service departments need to be
allocated to the departments that use their service in order to calculate the full cost.

According to GAAP
$35,000 AND $15,000 are considered expenses in
Income Statement

According to Internal Reporting

For management accounting and decision making,
must be allocated to the Production and Assembly
departments. (Also count in the extra costs regarding
the departments)

Criteria Used to Allocate Costs

1) Cause and Effect- used in order to be objective and get accepted by
the other departments and avoid conflict
2) Benefit Received
3) Fairness
4) Ability to Bear- (based on profit), sometimes managers may have
conflict on which department to bear the costs and is allocated by the
department that has lower costs (assembly), which is unacceptable and
usual results in dis-functional effect on management.

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 1. Direct Method
It is the simplest method and service department’s costs are allocated based on the services used
without regard to exchange of service between one service department and the other.

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 2. Step Down Method
Under this method of allocating costs of service departments, the service departments are
allocated in order, from the one that provides the most service to the other service department
that provides the least service.
In the exam, it will be mentioned with which department to begin the allocation with.

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 3. Reciprocal Method
This is the most accurate and complex method of all. It is also known as simultaneous solution,
cross allocation method, matrix allocation method or double distribution method. Services
between departments are recognized under this method.

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Single Rate VS Dual Rate Allocation
A single rate uses one base to allocate the overhead costs of Service Departments to Operating
Departments
Under dual rate it uses two bases to allocate the overhead costs of Service Departments to
Operating Departments,

Example

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